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Custody Rules Boost Third-Party Hedge Fund Aministrators

Date: Thursday, November 12, 2009
Author: Imogen Rose-Smith, Institutional Investor

In his most recent client letter, William Ackman, head of New York–based hedge fund firm Pershing Square, dutifully discussed market conditions. But he also explained in some detail why the $4.5 billion manager was one of 38 funds participating in Morgan Stanley Fund Services’ beta test of its new hedge fund custody and administration product, Stratum. That Ackman felt this development warranted mention is one more sign of how seriously hedge funds and funds of hedge funds are taking clients’ concerns about custody and transparency in the post-Madoff era.

"For years due diligence has been all about understanding the investment process," notes Charles Winkler, COO of $400 million New York hedge fund firm Hudson Bay Capital Management. These days investors are asking detailed questions about how the back office works. "This used to be a trust-me business," Winkler says. "Now it is trust but verify."

And even if clients weren’t insisting on greater openness, the Securities and Exchange Commission formally is. Embarrassed at not having uncovered Bernard Madoff’s Ponzi scheme, the SEC has sent out letters to hedge funds asking them to affirm that they possess the assets under management that they say they do.

The demand for heightened operational transparency promises to be a boon for the hedge fund administration industry. Many large funds in particular have long preferred to be self-administered, chiefly because they felt that conventional outside administrators were not capable of dealing with their complex investment strategies. But then, Madoff also favored self-administration, if for different reasons.

Not surprisingly, an almost immediate response to the Madoff scandal was a push by rattled investors to have hedge funds hire outside administrators. Many big multistrategy firms, including Caxton Associates, SAC Capital Advisors and D.E. Shaw Group, have done precisely that. Caxton hired State Street Global Advisors, and D.E. Shaw and SAC both signed on with Citco Fund Services.

"The role of the administrator is changing," points out William Keunen, director of fund services at Citco. "There is much greater demand, but administrators need to be able to demonstrate that they are up to the task and can provide the requisite checks and balances for large, complex hedge funds."

Nor is Madoff-style fraud investors’ only qualm. When Lehman Brothers Holdings filed for bankruptcy a year ago, more than $16 billion in hedge fund and other counterparty assets was trapped in its U.K. subsidiary. Naturally, investors also want to know a good deal more about where hedge funds are holding their securities.

Citadel Investment Group’s fund administration business, which it markets to other hedge fund firms and recently renamed Omnium (changed from Citadel Solutions, to distance it from the quantitative hedge fund), scored a major coup in August when it was appointed to handle Lehman’s assets.

Citco, Omnium and Morgan Stanley Fund Services are among the firms busily developing new products catering to the demands for greater openness. In his letter to clients, Pershing’s Ackman noted that every month there will be an MSFS Stratum statement independently verifying his fund’s assets and liabilities, price inputs, counterparty and service-provider identification, and classifications for SFAS No. 157 (a Financial Accounting Standards Board rule for valuation measurements).

Morgan Stanley asserts that it is the first to market with such a complete product. The bank is now pushing for hedge fund administration guidelines, including a protocol for verifying asset custody and agreed-on procedures for valuing esoteric and illiquid assets. "What we are promoting is an industrywide protocol," explains Seth Weinstein, chief executive of MSFS.

The firm has made its pitch to both the SEC and European regulators. Weinstein warns, however, that by adopting third-party administrators, hedge funds may create a false sense of security among investors. He points out that the U.S. still lacks universal standards or laws governing hedge fund administrators, and that the quality of reporting varies dramatically.